RFP - What's Resolute Forest Products' CVR Worth?

Summary

• After regulatory approvals, RFP should be acquired within the next 2 weeks.
• The cash consideration is $20.50, but the implied value of the CVR may offer upside to investors.
• Delving into trade policy suggests there could be upside from tariff refunds in the coming years, though it is uncertain.
• The current actions of the U.S. in obstructing WTO appointments do not suggest a resolution is imminent so this may be a longer-term investment.

Resolute Forest Products ( RFP ) should be acquired in "early March" for a cash consideration of $20.50/share and a Contingent Value Right ((CVR)) linked to potential repayment of U.S./Canadian softwood tariffs. Below is the recent update from the company in an 8-k dated 2/24/23 stating that regulatory issues are resolved and the merger should close "in early March 2023". This appears credible barring a totally unforeseen event.

As previously disclosed, on December 28, 2022, the Parent Parties announced that they had entered into a Consent Agreement with the Canadian Commissioner of Competition (the “Commissioner”) in connection with the merger, which was registered with the Canadian Competition Tribunal on December 28, 2022. The Commissioner issued a no-action letter on December 28, 2022, which terminated the applicable waiting period. The completion of the merger is also conditioned upon, among other things, the expiration or termination of any waiting period (and any extension thereof) applicable to the merger under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (the “HSR Act”). At 11:59 p.m., Eastern Time, on February 23, 2023, the waiting period applicable to the merger under the HSR Act expired and, with other required regulatory clearances having been obtained, all of the conditions to the closing of the merger have now been satisfied other than those that by their terms are to be satisfied at the closing. The Company and the Parent Parties currently expect the closing of the merger to occur in early March 2023.

The terms of the CVR are below from the most recent 10-K:

Under the CVR, stockholders will receive any refunds on approximately $500 million of deposits on softwood lumber duties paid by Resolute through June 30, 2022, including any interest thereon, net of certain expenses and of applicable taxes. Any proceeds attributable to the CVR will be distributed proportionally to the CVR holders, and the value will ultimately be determined by the terms and timing of the resolution of the softwood lumber dispute between Canada and the United States. The terms and timing of such resolution is uncertain

With a potential payout of $500M and 76.8M shares outstanding the CVR could be worth $6.51/share in the extreme upside case of a rapid and full payout. The implied CVR value is currently around $1.42/share so Mr. Market is crudely saying there's around a 20% chance of payout. That could be too low, though the payout is definitely uncertain and should be discounted.

History of the Softwood Lumber Dispute

Canada and U.S. compete in the market for softwood lumber, given they share a large border and both countries have material lumber industries. However, in Canada forest lands are often owned by the government, whereas in the U.S. forest lands are more likely to be privately held. This means that rather than incurring the cost of owning and maintaining the forest, Canadian lumber companies pay stumpage fees for softwood lumber. The U.S. has frequently argued that these stumpage fees are too low, creating an unfair advantage for U.S. lumber producers as Canadian suppliers can unfairly undercut them on price. This has led to impositions of tariffs and other import/export arrangements.

Historical Lumber Disputes

History suggests that lumber duties may be substantially refunded in 2-5 years. Given the current Lumber V dispute began in 2017, the dispute is running longer than earlier ones.

Is This Time Different?

There is some chance lumber V is different. Maybe the U.S. has become more protectionist in its trade policy and will continue to be. The U.S. dealings with China and in duties on aluminum and steel generally, are more protectionist than free-trade oriented, whereas previously the U.S. has tended to champion more of a global free trade agenda. This shift was initiated by President Trump, but hasn't demonstrably changed under President Biden, with WTO appointments still unfilled. This may mean the U.S. is less willing to end existing trade disputes than previously. Of course, this is not a debate about trade policy, but the U.S./Canada worldview and positioning on trade policy matters for the CVR payout.

Company CVR Valuation Estimates

Often in mergers and acquisitions, the companies own SEC disclosures via the merger proxy can provide insight. In this case the valuation of the CVR in disclosures is, unfortunately, not that enlightening. It is clear that the CVR was viewed as valuable during the negotiations, but the independent valuation only states that the chance of the CVR having value was somewhere between 0% and 80%, drawing heavily on the most recent outcome of U.S./Canada lumber disputes.

Valuing the CVR

It seems reasonably likely the softwood lumber duties will be repaid to some degree at some point in the coming years. However, we only have a few precedents to draw on and it's possible the political landscape has shifted such that the U.S. or Canada is unwilling to strike a deal. Also, there is some small chance that Domtar goes bankrupt before the CVR can be paid given the positioning of the CVR in the capital structure. Below are some scenarios applying a 10% discount rate and assuming that 70% of the duties are refunded. This results in a CVR valuation of $2.70/share or a total merger consideration of $23.20/share including the $20.50/share cash payment.

That suggests only ~6% upside which may seem unappealing, but assuming the deal closes as planned the $20.50/share is 'put to work' only for a few weeks, leaving ~90% upside on the CVR.

Sensitivities

For the CVR to be fairly valued today on the above framework you would expect a 60% chance that no deal is ever reached, or that any payout is around 35% of the duties owed. Applying a 40% discount rate (rather than 10%) also fairly values the CVR at current levels. These assumptions all seem too punitive, though of course, there is a degree of judgement in the analysis and an absence of defined inputs and base rates to draw on.

Why The Opportunity Exists

It seems as though CVRs may offer opportunities to investors. Whereas many can and do invest in publicly traded companies, CVRs are illiquid and uncertain, they can be complex to hold and difficult or perhaps impossible to trade. Once you own a non-tradable CVR there is no clear way to sell. Hence the set of willing investors for a CVR is likely a subset of investors in the overall market. That might cause CVRs to offer investment opportunities, depending on their payout expectations.

Risks

• The CVR is a general, unsecured claim on Domtar. There is risk that if Domtar becomes financially distressed, then there will be no CVR payment regardless of the outcome of the softwood lumber dispute.
• The CVR is only a small portion of the CVR merger proceeds, if the deal didn't close investors could see material downside well in excess of the expected CVR value.
• The CVR is illiquid and not tradeable, this makes it unsuitable for many investors.
• The CVR carries other unique risks too, such as that the conditions for payment are met, but the CVR does not pay out.
• The U.S./Canada softwood lumber dispute may never be resolved, or not in a way that results in tariff repayments, making the CVR worthless.
• In order to build a material position in the CVR you may have to assume a larger than ideal position in RFP prior to closing given the CVR is only a fraction of RFP's value today.

Conclusion

It's hard to value the RFP CVR with any precision. However, it does seem reasonable to believe that it's worth more than the market's current valuation. Charlie Munger apparently said that you don't need to know a man's exact weight to know that he is fat, and here we don't know the CVR's precise value but can perhaps still suggest that it may be inexpensive. The largest risk is that we're in a new trade regime and that the U.S. pursues a fundamentally different trade policy compared to past decades and walks away from the WTO and similar bodies and/or refuses to be bound by their rulings. In such an environment of ongoing tariffs, the CVR would likely be worthless. On my rough numbers above the chance of that scenario would have to be 60% or more for the CVR to have expected downside. I suspect that's too high and that the U.S. and Canada will ultimately work out a resolution, albeit a drawn-out one over a period of years. The admittedly limited history of softwood disputes does suggest that these disputes are often resolved albeit slowly and without full refunds on tariffs paid. In that scenario the CVR could be worth more than its current value implies, but only for very patient investors who can tolerate illiquidity and the risk of the CVR being worthless.

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